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The Price-to-Earnings Ratio Is a Formula (P/E) and So Is Einstein’s Mass-Energy Equivalence (E=MC squared); We Hope Investors Understand That There Is a Lot of Thought Behind Both

publication date: Sep 6, 2013
author/source: Brian Nelson, CFA

By: Brian Nelson, CFA


I Couldn’t Sleep Last Night

I was reading an article about the price-to-earnings (PE) ratio yesterday from one of our competitors that…I think…was attempting to sell its data screener to unsuspecting readers. The article made it sound like the PE ratio was the holy grail of investing, and if investors just used it, they’d be well on their way to knowing everything there is to know about valuation.

First, I was saddened. This competitor has far greater reach than Valuentum, and having trained hundreds of equity and credit analysts across three continents, I know that instructing analysts with 20+ years of experience on how to ‘unlearn’ the wrong ways of doing things is a lot harder than molding a freshly-minted graduate into a top analyst on the Street. When our competitors engage in these types of shenanigans, they are making Valuentum’s work harder – much harder.  

Second, I was overwhelmed. I suddenly remembered that, in the many years I have been in this business, I have come across dozens of articles just like the one our competitor had recently printed. It got me thinking that it’s nearly impossible nowadays for a pure, open-minded learner to actually find good information to absorb – and what I mean by good is accurate, complete information (I don’t think our competitor was purposely trying to mislead but probably just trying to sell its product). I believe the financial industry has now become more about what a select few with large distribution mechanisms/networks think than what actually is the truth. For those that know me personally, you can probably imagine that I was starting to breathe heavily at this point.

And then I became terrified. What if investors, after reading the article from our competitor, become armed with a sense of invincibility and scoop up every low-PE stock out there, thinking that they had found the secret to perpetual outperformance? After all, the market has gone straight up this year, so unsuspecting readers might be drawn in and associate one with the other. Frankly, I am terrified at how some investors seek only immediate gratification—meaning that if an idea doesn’t work out in the next two weeks, something is wrong. After all, look at some of the advertising out there: real-time and millisecond quotes. It’s as if real-time or up-to-the-second is better than correct. I’ll take being correct over “fast-and-furious” any day of the week.

I was up all night mulling over these thoughts. But I’m hoping that conveying Valuentum’s views on the construction of the PE ratio might help me sleep better tonight. At the very least, we'll put correct, complete information out there. So here goes…

The Price-to-Earnings Ratio is a Formula (P/E) and So Is Einstein’s Mass-Energy Equivalence (E=MC squared): We Hope Investors Understand That There Is a Lot of Thought Behind Both

The price-to-earnings (PE) ratio seems so easy, right? The trailing PE is just the price per share of the stock divided by the annual net diluted earnings per share the firm generated in its last fiscal year. The forward PE is the price per share of the stock divided by next fiscal year’s annual net diluted earnings per share of the firm (or the forward 12-month period).

The PE is probably the most common measure to help investors compare how cheap or expensive a firm’s shares are, as stock prices, for lack of a better term, are arbitrary. For example, firms like Warren Buffett’s Berkshire Hathaway (BRK.A), which has never split its stock, have traded as high as $175,000 per share, while other well-known companies like Sprint (S) can trade for just a few bucks per share. And Citigroup (C) was once a penny stock before its 10-to-1 reverse split in 2011.

It’s only when investors compare a firm’s share price to its annual net diluted earnings per share that they can get a sense for whether a company’s shares are expensive (overvalued) or cheap (undervalued). The higher the PE, the more expensive the company’s stock – all else equal. This seems way too simple, so why would we (or better yet, how could we) devote so much time to talking about such a basic financial concept? Well, the truth is that the PE ratio is not as simple as you think (and even some of the most seasoned investors continue to use this powerful multiple incorrectly).

How the PE Ratio Is Used Incorrectly

As Valuentum members know, the second pillar of our Valuentum Buying Index™ considers a company’s forward PE ratio by comparing this measure to that of its industry peers to determine if the company is trading at a comparatively attractive valuation. If the firm’s PE is lower than its peer median, an investor is paying less per unit of earnings than the median of its peer group. Investors are getting a good deal in this case, all else equal, right? Well, the problem is that companies are never equal, and even comparisons among firms that are in the same industry can be misleading.

It is also inappropriate for investors to apply a firm’s historical median (or average) price-to-earnings ratio to the same firm’s future earnings stream. But why? It’s the same stock. Shouldn’t it be relevant and applicable? Well, yes and no. First, it’s great for investors to have an idea of what “multiple range” a company has traded at in the past – there’s lots of value to this, and most relevant for cyclical firms (mainly industrials) that may, from a fundamental standpoint, exhibit similar (but not identical) patterns with respect to both earnings and their PE through the course of each economy cycle: think Boeing (BA) and the commercial aerospace cycle; Ford (F) and consumer demand for auto sales; or United Continental (UAL) with respect to premium air travel demand. But for less-cyclical firms (and even for cyclicals where structural industry dynamics have altered over time), investors are wrongly assuming that the forward outlook of the past (which determined the historical multiple) will be the same as the forward outlook of the present (which determines the current multiple). This, unfortunately, is never true.

So what is an investor to do? We know that it’s imperfect to compare a firm’s current or forward PE ratio to its peers or even to the median or average of its peers. No two firms are identical. And it’s even more imperfect to compare a firm’s current or forward price-to-earnings ratio to its historical measure. Look at Apple’s outlook in 2002 versus its outlook in 2009 – a lot different, would you say? One wouldn’t apply the same multiple to Apple in both years, or if you did, it would be for different reasons/underlying factors.

Why Do We Use the PE Ratio

Okay, you may then ask: why does Valuentum use a PE ratio at all in its process if the measure is so imperfect? Good question. The answer rests in its simplicity – and also stems from the reasons behind our writing this article in the first place. All investors do not use a discounted cash-flow process to value equities, and as a result, resort to the PE ratio to make decisions. As a result, there exists what we’d describe to be self-fulfilling market forces (buying and selling) that make the price-to-earnings ratio a meaningful consideration.

In other words, if Portfolio Manager A likes a stock because its PE ratio is trading at the lower end of its historical PE valuation range or is trading at a discount to its peers’ average PE, he/she might buy it, and this buying pressure itself causes the stock to rise, therefore making the PE in this form relevant. In other words, if other investors (especially the ones with deep pockets) are paying attention to it, you should, too. In fact, this idea hits at the heart of our process at Valuentum – striving to have a complete understanding of all market forces (investment philosophies) that drive stock prices, such that we can capitalize on them. For this reason, and this reason alone, we include a relative value assessment in our process, and the forward PE and PEG (price-earnings-to-growth) ratios, more specifically.

How Do We View the PE Ratio

So, with that said, how do we look at the PE then? Valuentum followers know that we use a discounted cash-flow valuation process (the first pillar of our Valuentum Buying Index) to uncover the intrinsic worth of every company in our coverage universe. Okay, now you may ask: “Why do you use a free cash flow model when stock prices are driven by earnings? Didn’t we just define the stock price as a function of its earnings and a P/E multiple (the share price divided by net diluted earnings per share is the PE)?” Well, yes. But earnings are a component of cash flow, and evaluating future free cash flows has its benefits.

For starters, the variations between earnings and cash flow not only arise in working capital changes over time (their influence on a firm’s cash flow from operations), but also in the timing of the cost of replacing those assets that generate earnings (capital expenditures versus depreciation). Plus, varying levels of interest rates paid on debt loads can also muddy the waters on earnings – not to mention that there are various ways to account for rent expense (whether to capitalize such assets or to allow the expense to flow through the operating line). So there are some major differences between assessing a company’s value based on earnings versus based on using a discounted cash-flow model. And because earnings quality (are earnings being converted to cash flow?) and capital efficiency (how much capital needs to be plowed back into the firm to maintain earnings) are critical to assessing the health of a company and its valuation, using free cash flow to evaluate companies is a superior process.

My Aha Moment…sometime in 2006

But what many investors fail to understand is that the P/E multiple is precisely – you guessed it – a short-form discounted cash-flow model. I first uncovered this groundbreaking relationship with a number of my colleagues back in 2006 when I guess you can say my ‘aha’ moment happened.

You’re probably like “great, but what does this mean?” Well, a PE ratio is not to be calculated from the stock price to determine if the stock is cheap or expensive, but instead, it should be derived from the company’s fundamentals to determine where the firm should be trading at.

It basically represents the difference between saying a firm is trading at 20 times earnings and saying a firm SHOULD be trading at 20 times earnings. A stock trading at 20 times may be cheap or expensive in the first case, but we know that a stock trading at 20 times is fairly valued in the second.

In order to discover what PE multiple is appropriate to place on a firm’s earnings stream (its net diluted earnings per share) to arrive at a fair value or price target, investors use a discounted cash flow process.

By calculating the present value of a company’s future enterprise free cash flows, factoring in the firm’s net balance sheet impact and making other adjustments (and then dividing by diluted shares outstanding), the investor arrives at equity value per share. Taking this equity value per share and dividing it by next fiscal year’s earnings of the firm leaves you with – drum roll please – the forward price-to-earnings (P/E) ratio.

Because a discounted cash-flow process captures the unique intricacies of the exact firm one is modeling at the exact time one is modeling it (and taking into consideration all future factors at the time), it is far superior to any relative peer or historical PE multiple analysis.

2006 was a great year.

Why We’re Fans of the Discounted Free Cash Flow Model

By now, you can probably see why we’re such big fans of using a discounted free cash flow valuation model. Though there are many, many ways of looking at a stock—in fact, varying perspectives remain core to our process—using a free cash flow process is perhaps the only way investors can truly arrive at the “correct” intrinsic PE multiple to place on a company’s earnings.

Let’s examine this even further. For example, have you ever wondered why capital-light companies (software, advertising companies) garner higher earnings multiples than capital-intensive companies (auto manufacturers)?  Well, capital-intensive companies have to re-invest a significant amount of earnings back into their businesses, thereby reducing future free cash flow, and by extension, the PE multiple investors are willing to pay for that earnings stream. Simply put, not all earnings streams are created equal – even given equivalent future expected growth trajectories in them. Investors should prefer the earnings stream in this case that requires the least amount of re-invested maintenance capital.

Nuts & Bolts

Okay…on to demystifying the PE ratio. At this point, we hope that we have at least convinced you to be careful about arbitrarily placing a PE multiple on a firm’s next year’s earnings to arrive at a target price (fair value). Even if that multiple is based on historical ranges (medians or averages) or is comparable to industry peers, investors fall short of capturing the uniqueness of a company’s future cash flow stream via a discounted cash flow process, which considers all of the qualitative factors of a company –from a competitive assessment to the company's efficiency initiatives and beyond (yes, even management’s strategy). Using a discounted free cash flow model forces investors to think about the key valuation drivers of a company long into the future, thereby reinforcing forward-looking analysis and a critical understanding of what we’d describe as needle-moving inputs (revenue, WACC, etc.).

Even analysts with 20+ years’ experience need help in this area. Trust me.

Without further delay, below is our complete definition of the price-to-earnings ratio. It’s not all that sexy, but neither are all the nuts and bolts behind Einstein’s mass-energy equivalence. You’ll notice that the PE ratio is forward-looking and considers many more components than many investors think:

Forward Price to Earnings Ratio = {[(Sum of Discounted Future Enterprise Free Cash Flows – Total Debt – Preferred Stock + Total Cash)/Shares Outstanding]/ Next Fiscal Year’s Earnings Per Share}

So Then, What Are the Drivers of a Firm’s Stock Price?

Upon further examination of the definition of the PE ratio above, one can see that it is just a short-form discounted cash-flow model. And because the PE ratio is also a function of the price of a stock, the factors of a discounted cash-flow model then become the drivers behind the firm's stock price. Below, we show how a number of qualitative factors influence the PE multiple and (by extension) stock prices and whether each factor is positively or negatively correlated to them. You'll notice the list is much more comprehensive than what many investors point to as the main reason for different PE ratios: varying future growth rates.

Revenue Growth: Impacts Future Enterprise Cash Flows (Mostly Positive)

Operating Earnings Growth: Impacts Future Enterprise Cash Flows (Positive)

Taxes: Impacts After-tax Earnings; Cost of Debt (Mostly Negative)

Capital Expenditures: Impacts Future Enterprise Cash Flows (Negative)

Return on Invested Capital (ROIC): Function of Operating Earnings and Net New Investment, Capital Expenditures (Positive)

Risk-free Rate, 10-year Treasury: Impacts WACC (Negative)

Discount Rate (WACC): Impacts Present Value of Enterprise Cash Flows (Negative)

Total Debt: Impacts Enterprise Value and Discount Rate (Mostly Negative)

Preferred Stock: Impacts Enterprise Value and Discount Rate (Mostly Negative)

Total Cash: Impacts Enterprise Value (Positive)

Shares Outstanding: Changes in Shares Outstanding (Neutral, assuming reinvestments' ROIC equal the firm’s WACC)

Key Takeaways

The key takeways are: 1) without using a discounted cash-flow model, the PE ratio that should be applied to a company's earnings stream can never be appropriately solved, and by extension, 2) when investors assign an arbitrary price-to-earnings multiple to a company’s earnings (based on historical trends or industry peers), they are essentially making estimates for all of the drivers behind a discounted cash-flow model in one fell swoop (and sometimes hastily). This ends badly almost all of the time.

As earnings for next year are often within sight and can be estimated with some confidence (though this certainly varies among firms), calculating the price-to-earnings ratio, in our opinion, is of far greater importance than worrying about whether a firm will beat or miss earnings in its next fiscal year. Because the PE ratio is a discounted cash-flow model that considers the long-term qualitative dynamics of a particular entity, cash-flow analysis remains the first and most important pillar of our Valuentum Buying Index.

As with Einstein’s mass-energy equivalence, the PE ratio is a formula, and both have deep, underlying theoretical support. Just like you can't stop at 'e=mc squared' to fully understand all of physics, you can't stop at the PE ratio (or any ratio for the matter) to fully understand all of valuation.


Now I can sleep!

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